Friday, March 16, 2007

The Bernanke Fed

In a recent speech by Charles Plosser, President of the Federal Reserve Bank of Philadelphia he discusses policy saying, "many of people’s economic decisions are affected by their expectations about the future course of monetary policy. As a result, the central bank faces a time-inconsistency problem. That is, it will be tempted to pursue policies that deliver temporary economic benefits that may be inconsistent with longer-term goals. And realizing that the central bank will have the latitude to give into this temptation, people will make decisions today that drive the economy to a suboptimal outcome. [As an example,] it is widely acknowledged that in the long run, monetary policy cannot raise the level of output or employment. However, due to various rigidities in the economy, the monetary authority may face a short-run tradeoff: by generating unexpectedly high inflation it may be able to temporarily boost output and employment. By like token, unexpectedly low inflation may temporarily reduce output and employment."

"Economic analysis tells us that as long as the prospect of exploiting this short-run tradeoff exists, a central bank conducting a discretionary monetary policy will not be able to achieve its desired rate of inflation. To see the reason why, imagine the monetary authority announces it is going to maintain average inflation at some desired level. If policy successfully maintains that desired inflation rate, then output would grow at trend. But at some point the monetary authority will be tempted to exercise its discretion to generate a bit more inflation, which may not be very costly, in exchange for the benefit of more output in the short run. However, once the higher inflation is recognized, the public will revise its expectations of future inflation and push wages and prices up. Consequently, the monetary authority will see higher inflation, but no higher output. It might be tempted to try the same experiment again, but it will generate the same outcome. Thus, the monetary authority’s attempt to increase public welfare will be thwarted by the behavior of forward-looking individuals and will end up producing more inflation with no added output. The monetary authority now faces a dilemma: if it seeks to re-establish its desired inflation rate, it must generate unexpectedly low inflation, risking a temporary decline in output. The loss of output would diminish public welfare; thus it seems unlikely that policymakers will undertake such action, and so the economy gets stuck with a permanently higher inflation rate than it desires. Thus, discretionary monetary policy proves to be time inconsistent and so fails to deliver on the desired inflation objective."

"Now, what if the monetary authority could commit itself, in some way, to producing the desired inflation rate that it had announced? The answer is clear. The public would expect that inflation rate would be maintained, there would be no unanticipated inflation, and output would grow at trend. So a monetary authority that could commit to its desired inflation policy would outperform a monetary authority that is free to exercise discretion—that is, it would deliver the same output growth, but lower inflation rate. Some people may find this result counterintuitive . . . People often think that keeping monetary policy from deviating from a desired inflation goal is like tying the policymaker’s hands and, therefore, should yield worse outcomes. But in fact, doing so gives a better outcome."

Why the long quote here? We think the Bernanke Fed, through its actions and statements intends to operate in a way that is fundamentely different than experienced under the Greenspan Fed. Under Greenspan, the Fed reacted to virtually every wiggle in the domestic and international economy. As a consequence, it was largely responsible for the dot-com bubble, the commodities bubble and the housing bubble. We believe the Bernanke Fed intends to reestablish the Fed as a stable institution that lays out clear expectations - and in the process, tamps down some of the wild speculation and volatility in asset classes. As a starting point, the Bernanke Fed seems willing to let the sub-prime loan and housing problems run their course.

Plosser goes on to say, "a policy governed by commitment dominates one of discretion. The question now is: How do we get commitment?" It is interesting to note that throughout the speech he tried defending the Greenspan speech yet his question implies a lack of commitment evident in the past Fed. He says, "we are very fortunate to have in Ben Bernanke another Chairman whose commitment is equally as strong." This is putting lipstick on a pig. Greenspan was the ultimate user of discretion - commitment was not in his vocabulary. Yet Plosser makes it clear that the current Fed intends to honor commitment and provide consistent messages: "there is a realization in monetary policy-making circles that maintaining credibility for low inflation is an important aspect of good monetary policy. Furthermore, it is important to be transparent so that the public’s expectations and the objectives of monetary policy are better aligned. Achieving this alignment ultimately furthers the central bank’s objective of maintaining stable prices while fostering full employment."

This is a new world in Fed policy. Look for lower volatility in asset classes as this message begins to sink in over the next several years.

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